Page 568 - F2 Integrated Workbook STUDENT 2019

F2: Advanced Financial Reporting

18.5 A

A is unreasonable as we do not know enough information to state that JS is
definitely insolvent.

The current ratio is a good indicator as to when a business is insolvent. If
current ratio falls below 1 this can be a precarious position and suggest high
risk of the entity being unable to settle its current liabilities.

However, what is deemed as a healthy current ratio is industry specific. It is
impossible to state that a business is definitely insolvent based on the current
ratio alone.

For example, large supermarkets do not sell on credit so have minimal
receivables, will invest their cash balances to improve their efficiency and, as a
lot of inventory is perishable, they will strive to ensure inventory is at as low a
level as possible. They also demand long payment terms from their suppliers in
return for their business.

As a result, supermarkets have relatively low current assets and relatively large
current liabilities. This would lead to a healthy current ratio for the industry being
lower than other industries (e.g. less than 1). Therefore, it is not guaranteed that
the business will have to be liquidated. Consideration of other information, such
as industry averages, would be considered before concluded that liquidation is
necessary.

Increasing the time it takes to pay suppliers would increase current liabilities
and thus reduce CR.

Reducing credit terms should reduce trade receivables and therefore would
reduce current ratio.

As stated above, supermarkets can survive with low current ratios.

18.6 C

A one-off credit to the profit and loss is likely to increase profit before interest
and therefore interest cover would be expected to increase.

Finance costs would be expected to increase following increases in long term
debt. This is likely to reduce the level of interest cover.

Falling margins would reduce profit before interest. More leases would increase
the levels of finance cost. Therefore, both explanations would be expected to
reduce interest cover.

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